Many Income Stocks Significantly Overvalued At Today's Prices

Wow, why own any stock if it doesn't pay a dividend. While the S&P 500 and its tracking exchange traded fund, SPY, have rallied nearly 20% since the summer lows of last year, and stocks such as Apple (NASDAQ:AAPL), have rallied over 30% in the last year, the recent sell-off has been brutal.

While the S&P 500 is down around 10%, most cyclical sectors, such as energy, the industrials, and the financials, have sold-off hard. Market leaders such as General Electric (NYSE:GE), Caterpillar (NYSE:CAT), Citigroup (NYSE:C), have sold-off nearly 20% in the last several months. Energy stocks such as Chevron (NYSE:CVX) and Exxon-Mobil (NYSE:XOM), have also performed poorly of late.

Indeed, the one sector that has held up strong in consumer staples. Specifically, many leading consumer staple stocks with high yields, such as AT&T (NYSE:T), Altria (NYSE:MO), Kraft (KFT), and Kimberly-Clark (NYSE:KMB), are at or near 52-week highs.

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While I have been a strong proponent of dividend investing for several years, recommending Lorillard in my first article, nearly 2 years ago, I think income investors are taking excessive risks with limited potential returns by investing in the leading dividend stocks that comprise most dividend mutual and exchange traded funds at today's levels.

Dividend investing is a powerful tool to maximize returns through compounding annual returns by reinvesting dividends at reasonable to cheap valuations. However, when stocks become moderately to significantly overvalued, reinvesting dividends only increases an investor's risk with minimal possibility of significant future gains.

This is exactly why I question the strategy of allocating new capital to the leading dividend stocks, such as AT&T, Altria, and Kimberly-Clark, at today's prices, for income.

AT&T currently trades at 14x an average estimate of next year earnings, the company and the stock currently yields around 5%. While AT&T has performed well over the last year, the company's growth rate from 2007 to 2009 was 3% a year, the company has nearly $65 billion in long-term debt, and AT&T subscriber growth this year was less than 1%. The company also eliminated its dividend entirely for a period of time in 2000. While AT&T offers stable dividend payouts today, the company eliminated its dividend just 12 years ago. AT&T also has a very high payout ratio of nearly 70%.

Altria is also yielding around 5%. While Philip Morris (NYSE:PM) was a strong growth and income stock for many years, today Altria's primary income is from the company's domestic tobacco business. Altria does have a significant stake in SAB Miller, and the company owns the St. Michelle Winery and several smokeless and chewing tobacco brands such as Skool and Copenhagen. Still, Altria gets over 80% of its revenue from its cigarette business, and the company's market share is around 50%.

The company's net income has declined for three years, cigarette volumes are shrinking each year, the company's payout ratio is 80%, and the stock is trading at around 14x an average estimate of next year's likely earnings despite analyst projections for a 4%-6% growth rate over the next several years. Altria also still faces some litigation and tax issues, with the company barely defeating a recent California proposal to raise the tobacco tax by nearly $1.

Kimberly-Clark currently trades at 15x an average estimate of next year's likely earnings despite having earnings growth of around 4% a year over the last 5 years, and 7% dividend growth. Kimberly-Clark has a very high payout ratio of around 70%, and the company has debt-to-equity ratio of around 120%, despite showing strong coverage of interest rate payments.

Kimberly-Clark benefits significantly from falling energy and commodity prices since many of the company's consumer products are petro products, and energy prices have fallen nearly 30% in the last several months. Still, while a strong dollar and weak demand from emerging markets is pressuring commodity prices today, long-term, demand for energy is likely to rise, and the U.S.'s significant deficit will likely prevent the dollar from remaining strong longer term.

To conclude, while dividend investing is a powerful way to maximize income and total returns longer term, investors can likely find many safer ways to obtain an inflation adjusted return of 4%-5% without being in equities if income is the primary goal. While fixed rate annuities often offer returns that are indexed to low interest rates, many variable rate annuities guarantee principle and offer inflation adjusted returns that have averaged 5%-6% or more a year over the last several decades.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.